Quarterly update | 3Q 2018 | EP18
This episode features insights from the third quarter by Greg Peterson, portfolio manager of Mawer’s balanced and global balanced strategies.
- Emerging markets
- Rising interest rates
- USMCA formerly known as NAFTA
A transcript of this episode is available below, modified for a more enjoyable reading experience. For more posts exploring the ideas we talk about in the episode, check out our Related Reads links.
Cameron Webster, CFA, MBA
Institutional Portfolio Manager
Cam likes to think and act long-term. He has broad experience in the capital markets over his 20+ years as an analyst, portfolio manager, and client service professional. When not thinking about markets and investing, Cam trains and participates in other “boring” and disciplined activities such as ultra-endurance races—marathon, triathlon, one-day 300+km bike rides.
With me today is Greg Peterson. He's our lead portfolio manager on all our balanced strategies, and we're here to talk about the third quarter of 2018. Greg, it seems like so far this year, it may not have been a “sell in May and go away” type thing. Markets overall year-to-date have been positive; returns are positive. In the third quarter, there seemed to be a few risks rising, so why don't you walk us through what the asset mix committee was talking about throughout the quarter?
Yes, it wasn't a bad summer overall for equity investors, so it wasn't a year to sell, disappear, and try and come back again. The market stayed fairly active through the course of the summer and the news flow was pretty active as well, so it wasn't really one of those quiet years.
The U.S. market, in particular, led the way over the course of the summer. Maybe it wasn't as good here in Canada, where energy and material stocks were weaker and lost over the course of the quarter—but the U.S. continues to do quite good.
There’s a fair bit of momentum there, despite the fact that interest rates had been moving higher in the U.S. and bond yields have also been moving higher.
The good news on the equity side is it has continued to keep stock markets moving fairly positive.
I'll pause you there. What I want to understand is, what's driving the U.S.?
The U.S. is continuing to benefit from the tax cuts that the Trump administration implemented. Businesses have more cash to work with, either to reinvest, or pay out to investors for them to spend in term—so that's helped. Profitability has been better. This is a bit of a late cycle kick for the U.S. economy that you wouldn't normally get.
You don't typically get fiscal stimulus injected at the time that monetary policy is starting to tighten or normalize, and raise interest rates. They've likely protracted the U.S. cycle somewhat by doing this—and it probably has a bit of momentum to carry from here to the next while as well.
Is there an argument, Greg, that we can continue to see corporate profitability and, I guess, the Federal Reserve move rates up gradually? Can they move in tandem? Or are we going to hit some kind of point? You said late cycle. What do we mean by late cycle? What can happen in late cycles?
That's a great question. They can move in tandem for sure. Typically, as you're getting into a later cycle, unemployment is running very low. In the U.S. right now, it’s up 4% so it's a pretty healthy time for people working in the U.S. Wages are growing and reasonably good, so it gives people the confidence to spend.
At the same time (just while I'm on the consumer in the U.S.), they've been deleveraging for the past few years, so consumer debt levels in the U.S. have actually improved significantly—so they're in a better position to spend.
Typically, that would be getting into the later part of a cycle because usually what happens at this point is that tightness in the U.S. market will start to cause inflation to rise. We have seen inflation firming and running fairly steady in the U.S. In fact, core inflation levels there are right around the Federal Reserve's target of 2%—bumping around on either side of that, but pretty consistent for the most part.
Usually at this point you have the Federal Reserve raising interest rates to keep inflation from running too quickly and from accelerating. Normally, what'll happen then is that interest rates are rising. That'll typically bring an end to that economic growth story and enter the cycle, if you will.
I guess for me, the counterargument to that would be: actually, the nominal level of interest rates are still pretty low. The risk that the Fed overtightens in this environment might be lower than, say, past cycles. Would you agree with that?
Yeah, I agree completely. Interest rates have just gotten to the point where real yields—or the real interest rate—in the United States has crossed zero, so it's just positive again. We've been in a position where interest rates have been less than the level of inflation for a long time. That's essentially negative real interest rates in the United States, which tends to encourage and feed the economy. And we've just got to the point where they're basically flat, or zero for the most part.
We're starting to creep into that positive real rate environment. I would expect that gives us some runway still for the U.S. economy to continue before we actually see the cycle start to age and come to an end.
Let's talk a little bit about what you have done, or how have you positioned, balanced portfolios at Mawer. Throughout the quarter as rates rise, there is a potential for fixed income investors to say: “well, actually, I'm getting paid more, but tilt the asset mix a little bit away from equities and toward bonds where yields are getting a little more attractive.”
We're getting to that point where bond yields are becoming a bit more appealing. They're looking better than the dividend yield. (For instance, on the S&P 500 in the United States.) Investors start to weigh the risk-reward between the two types of investments, and eventually, you get to the point where bonds with a lower risk profile at say 3.5% interest starts to look fairly appealing—compared to a lower dividend yield that carries more risk. So it does start to pull capital away from equity markets and into bonds.
What we've been doing with the balanced fund over the course of the summer is really just to keep equity from moving higher; we've had stronger equity markets. Bond markets have been a bit weaker, so the relative weight of equity moves higher within your portfolio as that happens. So we've been “keeping a lid” on equity—trying to keep it around 60%.
As equity weights have moved higher, primarily from the U.S. market being stronger, we've been trimming back and basically taking some profit from the U.S. side and redeploying that to bonds and cash to keep that mix from moving to become too risky within the portfolio.
That's a good transition point … to Canada! There's lots of trade news. We've gone from NAFTA to USMCA. I came up with US-MCA [pronounces literally] or a client of mine actually said NAFTA 2.0…take your pick. We've had some transition there, yet in the balanced portfolios, you're trimming U.S. equities, going to fixed income alternatives. You're not shifting the mix within equities.
Why would you go from U.S. equity, and why would you not go from U.S. equity into Canadian equities?
That's a good question, Cam. We've been looking at that for quite some time and evaluating Canada. We've had a few concerns about potential headwinds in the Canadian economy. Trade was certainly at the top of that list for some time, and it appears that we may have NAFTA resolved, or the free trade agreement moving forward, so that's reduced the risk of trade between Canada and the U.S.
The other concerns we have are household debt levels in Canada (they are record levels). Debt servicing costs are increasing for households in Canada. The consumer is still a major part of the Canadian economy at roughly two-thirds, so if it become more difficult for households to afford to spend money and consume—then it's difficult for the Canadian economy to continue to grow. So we do have some concerns around that.
In addition, we still have trouble with exporting energy out of Canada. There's been some small progress in the last little while, but it's still a risk going forward. If you look at the price that Canadian oil companies are receiving for their product, it's a significant discount to what American companies get for oil. WTI right now is trading between US$70 and $75. Canadian companies are getting somewhere in the neighborhood of US$40 for a barrel of heavy oil. It's quite a discount here. Until we have the ability to ship our product more freely, it's difficult to see that spread changing significantly. It is certainly a headwind for the energy sector in Canada.
So, so far—we just haven't added much to Canada. We are underweight Canada slightly within the equity portion of the portfolios with a view to one day change that, but we just don't feel that this is the time to bring that up.
Canada has got some great companies because the performance here has not been as attractive as other places in the last year and a half or so. Canadian valuations are also becoming a bit more appealing. So, we're just waiting for some signs that some of those headwinds are abating before we start to add here.
It's hard not to keep that home country bias and want to add to names that we’re very familiar with, companies that we know very well. We know the companies very well that we invest in—reforming companies as well—but you always have that preference to invest in home. So far, we still have a significant allocation here to Canada, just not as much as we might otherwise.
Yes, but within the overall balance mix, you’re bringing cash, fixed income…your total Canadian weight within the total portfolio is still quite significant. From a currency point of view… still biased toward Canadian dollars, for sure.
Yes, from a currency perspective, the balanced fund is about 55% Canadian dollar and the balance in other foreign currencies.
That's a good segue into other foreign currencies! Certainly in the quarter there were a few emerging market currencies that “took it on the chin”—so to speak. Argentina and Turkey were both over 25% down versus the U.S. dollar. Let's get into a little bit of explanation for investors about what went on in the quarter with regards to emerging market currencies.
It's a more challenging time for emerging markets in general. Typically, as you have the U.S. raising interest rates—and basically pulling liquidity out of the global system—that makes it more difficult for emerging markets, so money tends to flow away from those areas. At the same time, the U.S. dollar has been relatively strong. Many emerging markets have their foreign debt holdings denominated in U.S. dollars, so they have the double pressure of having to pay higher interest rates for U.S. dollar debt, and at the same time, their currency is not worth as much as the U.S. dollar, so it's also more expensive for them to repay that debt.
Those are two headwinds emerging markets face that, from a macro perspective, make things more difficult for them. I think some of the concerns around trade and a bit of uncertainty globally around trade has also contributed to difficulties for emerging markets. They tend to be deemed “higher risk” so if there's some concerns around trade, or a risk in general and uncertainties rising, then money would tend to flow away from those perceived riskier areas first.
There were some special circumstances in the last few months with the two you mentioned: Turkey and Argentina. Those are risks very much associated with those countries in particular; and political change within those countries. I wouldn't take what's happening there and label all emerging markets the same way. Our emerging markets team does a good job of looking to find very good companies in those parts of the world. There were a few countries in Venezuela I would also throw in there that were having a very difficult time politically and socially. Not all emerging markets are going through that.
There are some great companies and countries that will continue to evolve. I wouldn't doubt that those are areas that we’ll find value in the near future, or not too distant future, as there are good companies there that are growing…and you're trying to look around the world to areas that are continuing to grow and have that upside.
I suspect that's where we'd find better evaluations. While we watched emerging markets drop in the last little while and have very weak performance, it sets up your future potential for investing as well.
So what I think I'm hearing is there might be a higher risk profile in emerging markets. On the flip side of that…you get this effect where you can actually find a South Korean company whose major revenue stream is U.S. dollars.
It’s difficult to imagine Samsung being a much more “risky” company because it’s domiciled in South Korea, as opposed to some other part of the world. You have household names that have very solid global businesses, but just happen to be from some of those countries that get tagged as an emerging market.
Let's switch a little bit from looking back on the quarter to looking forward—certainly we want to evaluate what the risks are out there. From an asset mix point of view, we're at our neutral level: 60% equity, 40% fixed income. Is there anything in the landscape going forward, Greg, that would suggest you change that?
I think as interest rates continue to rise—interest rates are a big part of equity valuations in addition to the direct impact that they have on bonds as well—that will pressure valuations on the equity side, and make equities look more expensive.
As we see earnings growth continue to decelerate, that would be another indicator for us to perhaps start reducing our equity weight from that 60%. We still think that currently, there's a bit of momentum on the earning side. It’s still positive. The earnings growth rate may have peaked, but growth is still positive. That keeps us confident enough to remain at 60%.
But as those start to tip over, valuations become less appealing—and they're already fully valued. We don't think that they're stretched beyond what's reasonable given the environment at the moment. (t's still a low rate environment for the most part.) But as that changes then we'll start to gradually change as well. We're not market timers. We're not going to try and look for the exact, perfect time to take equity lower. It's really responding to what we think are our elevating risks globally; elevating uncertainty. The picture looking forward two or three years is becoming a bit cloudier, and when you have difficulties seeing that far out with any sense of certainty, then you start to reduce the risk you have in the portfolio. That’s what tends to reduce the equity weight within the portfolio.
So we'll continue on the same path we've been down for some time now. If we go back a couple of years, equities were overweight within the balanced portfolios. We've been just very gradually trimming them to keep that from growing as a much higher weight within a balanced portfolio. We’ll continue to do that going forward, and eventually, we’ll tip over to the point where we start to bring equity slightly underweight as well. That's one approach from asset mix.
The other response to growing uncertainty, and the change in environment too, comes from the security selection. That's where the broader teams are involved in improving the companies we’re holding. We may not actually change the equity weight significantly, but the companies we're holding within the portfolios—that makeup is changing constantly to make sure that we're relatively defensive if we’re right that this is end of a cycle and stock markets are more pressured going forward.
Right. I've been hearing in research meetings throughout the quarter from the equity teams of de-emphasizing holdings that are now in the top range of their fair value (as we estimate it) and maybe tilting toward business models that have more recurring revenue.
Absolutely. Looking into those companies that have strong competitive advantages where cash flows can be seen with some certainty and are fairly reliable, and also looking for businesses that have low capital needs or less capital needs going in. If you have a very capital-intensive business that’s constantly having to go to market to raise money…as you get to the point where interest rates are moving higher, risk premiums perhaps are moving higher on equities as well, the market is demanding more…it's not the best time to go to market to try to raise capital. You want to deemphasize those companies as you get into this point.
Greg…what's an investor to do if, out in the market, everybody’s saying, “we're late in the cycle!” …but can the cycle keep going?
We do talk a lot about being late cycle, and it all sounds a little gloomy. But investors shouldn't really worry about this. I think a lot of this talk is to help set expectations that we’re coming to the end. News media loves to pick up on change. Negative news, quite frankly, attracts a lot more listeners for the most part.
Really, what investors need to do is make sure that they have their liquidity requirements satisfied. So if you need cash in the next year for certain purchases, or things that you know for absolute certain are going to take place—you have that already set up and built into your investment strategy.
Beyond that, it's really setting expectations, that yes, returns have been really good for many years now and are likely to slow.
We would expect going forward returns would be slower, perhaps negative from time-to-time, just as the uncertainty grows. It's not a bad thing. It does give your investment manager time to find new opportunities—perhaps stocks we followed for some time that we felt were fairly expensive. Suddenly, the market has delivered them a little bit cheaper. That's better for us for making some changes.
Set expectations and ensure that your investment policy is correct for you; that you have liquidity set aside, and really, just expect that the return should naturally slow for a period of time before we start into another cycle.
It's not the end of the world. It’s just a changing world.
Changing world—what a good way to end!
Thank you for being here again for the quarterly review. We'll have you on for the fourth quarter, year-end and—I don't know, sing a Christmas carol or two?
Thanks very much, Cam! I'll spare everybody the singing of the Christmas carols.
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